Friday, October 12, 2012

The Progressive Fiscal Cliff

Dylan Matthews of the Washington Post has a post up today that offers some interesting data on whom the "fiscal cliff" would hurt most, but he presents the data in a way that I believe invites misinterpretation.

Matthews draws on estimates from the Urban-Brookings Tax Policy Center of the impact of the "fiscal cliff" on marginal tax rates for various income cohorts. He performs what I view as a public service in calling attention to this data; while I can't vouch for the accuracy of the estimates, the focus on marginal rates is desirable.

Where he goes astray in my view is in his presentation of the data, which focuses on the percentage increase in each income cohort's marginal tax rate in the event that we go over the "fiscal cliff."

For example, a chart shows that the marginal income tax rate for people earning under $10,000 annually would see a 64% increase in their marginal tax rate, as they went from paying a 4.9% marginal rate in 2012 to an 8% marginal rate in 2013. The claim is indisputably true, in the sense that his algebra is correct, but in my estimation it creates a very misleading impression of the impact on economic incentives.

The more useful way to interpret the data is by focusing not on the impact on tax rates, but on the impact on after-tax income. In the example above, someone earning under $10,000 in 2012 keeps 95.1 cents of the next dollar he earns, and the "fiscal cliff" would reduce that to 92 cents in 2013. So while the 64% increase in this person's marginal tax rate sounds dramatic, the reality is a decline of just 3.3% in after-tax income ((8.0-4.9)/95.1). A person who keeps 92 cents of the next dollar they earn is unlikely to be discouraged by his tax rate from going out and earning it.

The effect is most dramatic at the extremes; Matthews' methodology creates an exaggerated impression of the impact on the incentive of lower-income people to earn that next dollar, and an understated impression of the impact on the incentives of high-earners.

Here is the data, with Matthews' numbers (the percentage rise in tax rate) on the left, and the actual decline in after-tax income on the right:

In other words, the "fiscal cliff" turns out to be rather progressive.

People earning between $500,000 and $1 million would see a 13.8% decline in their marginal after-tax income, and those earning over $1 million would see a 10% decline, while those earning under $75,000 would see declines ranging from 1% to 5.2%.

I sent Mr. Matthews a tweet about this, and even though he doesn't know me he was nice enough to reply:

Sure, but (a) the poor face the highest work disincentive increase and
(b) ability to pay is logarithmic. 5% of $20k is more important than 10% of $1 million.

Twitter doesn't lend itself to detailed discussion, but I think his first point alludes to the fact, which he notes in his post, that while low-income people appear to face a smaller impact from the "fiscal cliff" when viewed in isolation, the reality is that as benefits such as the EITC phase out, they face marginal rates that can only be described as confiscatory.

As with his algebra, this much is indisputable. The disincentives to work created as eligibility for benefits phases out are a huge problem, and one to which it is difficult to imagine any good solution without a substantial commitment of additional resources, which entails its own problems.

Yet I don't think this justifies the misleading portrayal of the effect on tax rates rather than on after-tax income. It easy enough to marshal the data to show effective marginal tax rates for people transitioning out of benefit eligibility; Matthews has done so himself in other posts. So I fail to see any good reason to risk one's credibility by presenting this data in such a misleading manner.

The second point, regarding the ability to pay, strikes me as a non sequitur. Any presumption about ability to pay is irrelevant to the calculation of what the tax burden actually is.

Moreover, while someone earning $1 million can presumably bear an increased tax rate more easily than someone earning $20,000, such a person can also more easily avail themselves of tax avoidance strategies, including exiting the labor market altogether. If you are earning a very modest income, you are unlikely to have any good alternatives to continuing to work no matter how high your tax rate goes. If you are earning seven figures or more, particularly if you have done so for a multi-year period, you are apt to have far more flexibility to decide you'd rather spend your time doing something other than making money. In short, willingness to bear a higher tax burden starts to become as important as ability to pay.

Matthews' post is still well worth reading in full, but it should be read while bearing in mind that the presentation of the data seems designed to create the impression that the "fiscal cliff" would most heavily impair the incentive to work of low-income people, when in fact the data do not support that conclusion.

Twitter doesn't lend itself to detailed discussion, but I think his first point alludes to the fact, which he notes in his post, that while low-income people appear to face a smaller impact from the "fiscal cliff" when viewed in isolation, the reality is that as benefits such as the EITC phase out, they face marginal rates that can only be described as confiscatory.